The stock market will likely resolve its near-term directionality because the 'selling stampede' is now 18 sessions long, compared to a usual range of 17 to 25 sessions.

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As long as the roots are not severed… there will be growth in the spring.
-- Chance "the gardener" in the book Being There

With the recent slowing of economic momentum, grumbles have surfaced again from various stock market gurus about another recession. To those groans this morning, I reference the book Being There by author Jerzy Kosinski. The story revolves around a simple-minded man named Chance "the gardener" who knows only gardening and what he sees on television. Indeed, for his whole adult life, Chance has not ventured outside the grounds of his employer's Washington, DC, manor.

Eventually, however, the employer dies and Chance is cast out onto the streets, where through a mishap he encounters the wife of a DC powerbroker. Thinking her car was the reason for the mishap, she insists that Chance "the gardener," who she interprets to be Chauncey Gardiner, come with her to her husband's estate. Benjamin Rand (the husband) is completely taken with Chauncey's simple, direct approach and mistakenly attaches profundities to Chauncey's ramblings about gardening. Viewing him somewhat as a savant, Rand introduces Chauncey to Washington's elite, including the president. In one verbal exchange regarding the current economic condition, Chauncey remarks, "As long as the roots are not severed there will be growth in the spring."

To be sure, it's spring again, and instead of the typical shouts of "As long as the roots are not severed there will be growth in the spring," many Wall Street pundits are worried about economic growth. Their worries center on our dysfunctional government, the housing/real estate situation, and Euroquake.

Speaking to the government, since the mid-term elections, I have suggested the Tea Party surfaced what Adam Smith wrote about in the book The Wealth of Nations. My prose read, "The Tea Party has surfaced what Adam Smith described as the 'political corruption that prevents prosperity'." And that's exactly what we've got; the best Congress (Senate and House) money can buy.

However, my sense is this is changing because if you parse the backgrounds of the newly elected members of Congress, you find that many of them are not professional politicians. Moreover, if you speak to them they will tell you they really don't want to be in Washington, but they think our country is off course and they want to fix it. I think this is one of the reasons the S&P 500 (SPX) rallied 16% following the 2010 mid-term elections into its May 2011 high. This year the SPX is also following the presidential-year script, as can be seen in the first chart below. Hopefully, this correlation will continue, driven by the bullish theme of more practical leaders.

As for housing, my firm's fundamental real estate team writes:

Last month, we shifted our tactical investment position on the homebuilders in a positive direction following trips to key homebuilding markets in Florida and Arizona. We believed (and have since confirmed) order results for the public builders would reflect surprising strength and a sharp acceleration in activity. We believe demand has remained strong in recent weeks as MDC (MDC) recently reported that April orders rose ~30% y/y (moderating from +51% y/y in 1Q), even as it lapped a big promotion event from last year. Also of note, Ryland (RYL) reported that net orders (from continuing operations) increased 37% y/y in April. [Further] the average home price rose 5.1% to $282,600 from $268,900 last year. Relative to March, sales increased in three regions, with the breakdown as follows: Northeast (up 7.7%), Midwest (up 28.2%), South (down 10.6%), and West (up 27.5%).

Of course, such improving metrics have been telegraphed for months by the S&P 1500 Homebuilders and lumber futures, as can be seen in the attendant chart below from Ed Hyman's sagacious ISI organization, whose mutual funds my firm embraces. Then there was this quip from Fiserv, "Average US home prices – down by a third since 2006 and still falling – will rise almost 4% a year for the next five years."

Last week, however, those two worries were again overshadowed by Euroquake as rumors swirled that Greece was going to pull out of the EU and Spain's second-largest mortgage lender, Bankia, was on the verge on insolvency. To those apprehensions, I repeat my belief of the past 12 months. To wit, having worked in Washington, I have a good understanding of politicians, bureaucrats, and bankers. Unsurprisingly, they are the same in Europe as they are here in that they do not want to lose power, and if the EU fails they all lose their power.

So my hunch is, and has been, the powers that be will continue to "paper over" the Euroquake situation and hope that time provides a solution. That said, I can envision a scenario whereby the weakest countries could leave the EU, while the stronger members stay. In fact, such a "partial break-up" might just be part of the solution and not the total disaster many expect. If so, this could prove positive not only for the EU, but for the rest of the world as well.

Such worries continue to leave investors profoundly underinvested in US equities; they're also why the SPX trades at a P/E multiple of less than 13x this year's estimate. With consensus earnings estimates centered around $103, and $119 for 2013, a return to the SPX's mean P/E ratio of 16.2x implies decent upside from here.

Further, this is one of the longest periods of time equities have been below their 50-year average valuation levels since 1973-1974. Back then, the worries du jour were about the OPEC oil embargo and the resulting oil prices, Watergate, President Richard Nixon's resignation, the collapse of Franklin National Bank, the near-bankruptcy of New York City...well, you get the idea. From that grim news backdrop, the Dow Jones Industrial Average (INDU) made its nominal price low in December 1974 at 577.60. While the Industrial's valuation low didn't arrive until August 1982, at 776.92, most stocks made their generational low prices in December 1974.

Fast forward and recall that on March 2, 2009, I stated the stock market would bottom that week and likened said bottom to the nominal price low of December 1974. Since October 4, 2011, I have additionally opined that "low" was probably the valuation low, which brings us to 2012.

My firm's work suggested the "buying stampede" ended on January 26, and subsequently we recommended raising cash in anticipation of a 5%-8% correction. While it took longer than expected, the correction finally arrived in April-May, culminating on May 18 with an intraday low of 1291.98 for the SPX.

At the time, all of the oversold indicators we use were at/near historic readings, and we recommended judiciously recommitting some cash to select stocks. Regrettably, since then the SPX's action has not been all that impressive. Indeed, the SPX has not even been able to claw its way back to my first target level of 1338, much less into the critical 1356-1366 zone. Yet, there is still time for this recovery to occur provided the SPX does not break decisively below 1290, for that would trigger a danger signal for further price erosion.

The call for this week: The stock market will likely resolve its near-term directionality because the "selling stampede" is now 18 sessions long, and such stampedes tend not to last for more than 17 to 25 sessions. Despite the decline, by my work there has been no Dow Theory "sell signal," although there are some Wall Street wags who are using very short-term pivot points and believe otherwise.

Still, the downside skein has left all of the indicators I monitor extremely oversold, suggestive of at least a near-term bounce. Such a rally would tell us a lot about the health of the market going forward in time, but if 1290 is violated I will need to rethink my bullish stance.

Interestingly, all of the indices I track were up on the week, with the economically sensitive Dow Jones Transports (TRAN) fairing the best with a 4.23% gain. Likewise, all of the macro sectors improved for the week, with best being materials (+3.72%). Surprisingly, the upside surge in corn and wheat stopped, but the driver of this duo's rally remains as temperatures soared into the 90s across the corn and wheat belt, accompanied by the Iowa's lowest rainfall in 40 years. That caused the US Agriculture Department to lower its rating for wheat in Kansas by nine points for the sharpest one-week ratings drop since 2007. This weather point is not unimportant, for if the warmest winter on record is followed by the hottest summer on record, there are all kinds of investment ramifications for water stocks, fertilizer stocks, air conditioning stocks, utilities, etc.

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